Is a Greek default inevitable?

By Kurt Brouwer

Update: Here is another look at what is going on with Greek bonds and those of other troubled European governments. This shows the interest rate spread between German government bonds (AKA bunds) and those of the named country. It is just another view of how bad things are getting over there because investors are demanding higher and higher interest rates to take on the risk of default:

Is a default by Greece likely in the next year or so? If this chart is correct, then the answer is no. However, if you asked if Greece is likely to default on its debt in the next five years then, the answer could well be different. This chart and report from the Council on Foreign Relations indicates that the bond market believes a Greek default is a high probability if you look ahead four years or more [emphasis added]:

The difference between Greek and German government bond yields can be used to estimate the market’s view of the likelihood of a Greek default. The chart above shows these probabilities over different time frames on three different dates. On April 30th, no European plan was yet in place to address the ballooning Greek debt, and default was considered a real possibility in the short term. On May 11th, just after the European Stabilization Mechanism (ESM) was announced, markets sharply cut their view on the odds of default across all time horizons. However, the market’s analysis of the ESM has become much more nuanced since then. On September 1st, the market’s view of the probability of default within two years was lower than before the ESM was announced, but higher over longer time frames.

Greece will happily borrow from the ESM to avoid having to close its primary deficit...Yet if Greece is successful in eliminating its primary deficit, its temptation to default will actually grow, as it can wipe out huge amounts of accumulated debt without any longer needing the financial markets to fund current expenditures. If faced with the choice between paying Greek debts and letting Greece default, its northern neighbors may, once their banks are on more solid footing, find it more attractive simply to let Greece default. This is the story line that the markets are now pricing into government bond spreads…

For a more lurid chart on the Greek problem, let’s turn back the hands of time to February when Pimco’s Bill Gross portrayed problem countries In his monthly investment commentary. He dubbed Greece, Italy, Japan and others as being in the Ring of Fire (see chart below). Gross was writing about national debt and the ‘ring of fire’ analogy comes from this section in his February Investment Outlook [emphasis added]:

…The most vulnerable countries in 2010 are shown in PIMCO’s chart “The Ring of Fire.” These red zone countries are ones with the potential for public debt to exceed 90% of GDP within a few years’ time, which would slow GDP by 1% or more. The yellow and green areas are considered to be the most conservative and potentially most solvent, with the potential for higher growth…

About Fundmastery Blog

Kurt Brouwer is a fee-only financial advisor with three decades of experience. He is the chairman and co-founder of Brouwer & Janachowski, LLC. Kurt has written books, articles and hundreds of blog posts on mutual funds, ETFs and other investment topics. E-mail: kurt.brouwer *at* gmail.com.